Pollution and its Institutional Investor Discount

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Can rising awareness about climate change cause businesses to operate in a more environmentally friendly manner?

Concerns over climate risks have increased among the public in recent years. In our previous studies, we confirmed that people’s beliefs about climate change tend to become stronger when they experience extreme weather personally. Also, both retail and institutional investors are reducing their holdings in high-emission companies as awareness about climate change increases.

But can climate change actually affect a listed company’s stock price and can it really affect its business decisions? In the study Carbon Stock Devaluation, we continued to examine how climate change and financial economics affect each other.

We observed that capital allocations from both institutional and retail investors and the real decisions made by public firms tend to go in the same direction, and one that lowers carbon emissions and helps combat climate change.

Prof. Jiang Wenxi

We first collected data from 26 major equity markets to examine the valuation gap between high- and low-emission stocks at the country level. The fact that such a gap exists implies that firms with higher greenhouse gas emissions face higher financing costs. Specifically, we looked at the average price-to-book ratio of firms with high emissions versus those which are cleaner.

We found that this gap was close to zero before 2011; after which it turned negative and increased significantly. This indicates that the valuation of high-emission firms has become lower than low-emission firms in recent years. More specifically, we found that, on average between the years 2007 and 2020, firms classified as high-emissions suffered from an 11.5 percent discount on their valuations, compared with companies with lower emissions.

We then examined whether this was associated with calls in recent years for investors to reduce their holdings in industries that are associated with generating high carbon emissions. What we found was that institutional and retail investors together reduced their holdings of companies with high emissions by about 0.09 percent each year.

While there could be many reasons for this, we argue that it is investors’ growing awareness of climate change that is one of the main driving forces. As expected, our results indicated that the price-to-book ratios of firms with high carbon emissions fell by 0.7 to 2.1 percent, compared to firms with lower emissions, around the timing of natural disasters. This is a time when people would be most concerned about the effects of climate change.

Given this association between investors’ climate awareness and lower equity prices of high-emission firms, we then sought to find out whether it could push companies to take action to combat climate change.

While some investors adjust their investment decisions in response to climate change, companies also face mounting pressure to become more environmentally friendly.

In general, our results confirmed that this is indeed taking place. We found that when the valuations of high-emission firms fall, these same companies would respond by taking actions that lower their carbon emissions.  In addition to reducing their carbon footprint, they would also increase the ratio of green patent fillings that allow them to operate in a more environmentally-friendly manner.

But how do high-emission firms finance their increasing green innovation activities when they face a higher cost of capital? We found that they do this by likely tapping into internal financing to tackle challenges, and downsizing their operations.

In this research, we observed that capital allocations from both institutional and retail investors and the real decisions made by public firms tend to go in the same direction, and one that lowers carbon emissions and helps combat climate change. However, we cannot claim that there is a causal relationship between the two actions. We found that private firms with large carbon footprints did not respond to climate change in the same way as their public counterparts, which may be due to the fact that they do not face similar divestment and price pressures directly. While climate awareness can be strengthened by tighter environmental regulations and firms’ own desire to be cleaner, our comparison between public and private firms highlights the important role of the equity market.

To find out more about a specific topic, click on the links below to navigate to the relevant chapter:

INTRODUCTION – The Unstoppable Rise of Sustainable Investing

PART I – Does Climate Change Sway Markets?

PART II – The Power of Institutional Investors

PART III – Pollution and its Institutional Investor Discount

PART IV – Does Regulatory Risk Affect Retail Investment Decisions?

CONCLUSION – Adapting to Changing Investor Sentiment